What is a P/E Ratio and Why is it So Special?

I’m here to finally tell what in the world a P/E Ratio is and why it matters to you to be profitable in stock market. No, a P/E ratio has nothing to do with high school physical education or how many pull-ups you can do but it can help tell you when you might be overpaying for a stock.

What Is a P/E Ratio?

Last time, we talked about ratios and how they can help you compare companies and select the best stock out of a bunch. The P/E Ratio is just one of the more important ratios that can tell you a lot about a company’s earnings and value.

The “P” in the P/E stands for “Price” and the “E” stands for Earnings. The “P” is the easiest to find – pull up a quote from any vendor and you’ll know exactly what the price of the company’s stock is trading at right now.

You’ll often hear the term “P/E Ratio” thrown about on TV when different talking heads are chatting about their favorite stocks. In fact, it can be an clever insult to tell an analyst that you think his favorite stock’s P/E Ratio is too high!

You may also hear it by its other name “Price Multiple” or even “Earnings Multiple.” Any of those names fit, but they all mean the same thing.

Calculating P/E Ratios

So how do you get this all-important number? The P/E Ratio often listed right on the main page of any stock you pull-up from your favorite stock website like Yahoo Finance, Google Finance, or MSN Money. You can find it where it says “P forward slash E” and it’s usually a relatively low number.

For example, right now, Microsoft (MSFT) has a P/E Ratio of 12.30, with it’s stock trading right now at $21.50 per share and an Earnings per Share value of $1.75. In comparison, Apple (AAPL) has a current P/E ratio of 25.0, as its stock is trading right now just above $140 with Earnings Per Share at $5.568. It’s not enough to look at the current price of a stock and determine how expensive it really is.

To calculate P/E yourself, just take the current stock price and divide that by the earnings per share, or value after “EPS.” Sometimes you’ll see “F P/E” which stands for Forward Price to Earnings Ratio, which is just a best-guess of what the company’s earnings per share will be into the future.

To calculate P/E yourself, just take the current stock price and divide that by the earnings per share, or value after “EPS.”

Why Should You Care About the P/E Ratio?

Why should you care about how high or low a company’s P/E Ratio is? You can use the P/E Ratio to judge whether a stock might be cheap or expensive. But be careful – a low P/E does not necessarily mean a stock is cheap just like a high P/E doesn’t mean a stock is expensive!

Don’t fall into this trap! You have to compare apples to apples! You have to put a stock’s P/E ratio into the proper context. For example, many ‘high-flying’ technology stocks such as Google (GOOG) – which has a current P/E Ratio of 31 – will almost always have higher P/E ratios than stocks in other industries, like the auto industry or or retail industry.

At the same time Google’s P/E Ratio is almost 30, Wal-mart (WMT)’s ratio is only 14.95 – almost 15. In comparison to Wal-Mart, Target stores (TGT) has a P/E Ratio of 14.83 – very close to Wal-Mart which is what we would expect.